Capital idea: The booming derivatives market gets its due

Derivatives are improving transparency and reducing volatility in financial markets.

On a recent trip to Montreal I stopped by the Montreal Exchange to have a coffee with Jean-Charles Robillard, the director of media relations and communications at the exchange. Sitting on a terrace outside the company's headquarters on Victoria Square, we talked about the remarkable success Canada's dedicated derivatives exchange has had over the past few years.

It was back in the early 1990s, of course, that the current CEO of the Montreal Exchange, Luc Bertrand, contacted the Vancouver and Toronto stock exchanges to initiate negotiations that eventually led to a reorganization of Canadian stock exchanges.

The resulting shuffle saw the Vancouver exchange take over small cap equity trading, the Toronto exchange focus on large cap equities, and the Montreal exchange specialize in derivatives. It was a prescient call on Bertrand's part. While the Toronto Stock Exchange struggles to maintain listings in an era of private equity buyouts and foreign acquisitions (which have seen some big names disappear from the S&P/TSX Composite index), it's a whole other world in derivatives. Trading in these obscure financial instruments has exploded and the exchanges that trade them are doing exceptionally well. The main U.S. derivative exchange in the United States, the Chicago Board of Trade, has been a darling of investors. Its stock has appreciated to US $200 a share, an amazing gain on its IPO price of $52 a share just over a year ago.

But no wonder the bump in value. This past week the Bank for International Settlements announced that the global derivatives market had grown a remarkable 39.5% in 2006, the fastest pace in nine years, while the value of bond-based derivatives doubled to $29 trillion. The CBOT also recently announced a new monthly record for volume on the exchange — 92,312,946 contracts were traded in May, a 16% gain over last year — while the Montreal Exchange (TSX: MXX) set its own one-day trading record on May 24th. Some 350,471 futures contracts based on the 10-year government of Canada bond — by far the ME's most popular product — were traded in one day. “They said he was nuts,” says Robillard, about Bertrand's choice to focus on derivatives trading. “Everyone ganged up on him, business people, the press. It looks much better these days.”

No kidding. The derivatives market is clearly the growth leader in capital markets. But what are these odd securities called derivatives? The simplest definition is that they are a security or contract based on (or derived from) an underlying security such as a commodity, stock or bond. The most common derivatives are futures contracts that, when bought, give the holder a right to buy (or sell) the underlying security at a certain price. That contract, the future contract, is the derivative, and that ability to “lock-in” future value of the underlying security has been of great value to industry.

Although we often think of derivatives as exotic financial instruments, they are actually a fairly mundane tool of finance that grew out of the agriculture sector. Early use of derivatives has been traced to the Japanese rice markets of the 1600s. But it was the grain markets of North America in the 1800s that gave rise to modern derivatives.

There is a reason the center of derivatives trading is still Chicago. The windy city is the traditional hub of the U.S. grain industry and it was there that farmers first began buying and selling commodity futures contracts. By locking into a futures contract in the spring a farmer knew then what he would get for his grain in the fall, and that made his life a whole lot easier. That basic principle has been warped into all kinds of new products, from swaps to options, and extended to all kinds of other industries.

Today one of the largest derivative markets is the market for credit default contracts, where you can buy a contract giving you the right to sell a certain corporate bond at such and such a price. That ensures the value of your portfolio in the case of default by the company issuing those bonds. But the concept has been extended to any number of products. You say your company makes fertilizer and you want to hedge your risk against a natural gas price spike (fertilizer production uses tons of natural gas)? Derivatives. You say you're organizing a massive outdoor festival and want to hedge against the possibility of being rained out? Look into weather derivatives, which are contracts that pay out according to temperature and rainfall patterns. In that sense, derivatives are a simple tool to help businesses manage the natural ups and downs of the business environment.

Nevertheless, derivatives are often fingered as a source of potential financial catastrophe. Like any financial instrument, derivatives can be used for speculative purposes. So can equities, of course, but critics point to the massively leveraged positions that can be achieved through derivatives. For that reason, some suggest derivatives are a particularly potent source of catastrophe. Warren Buffett, in his 2006 letter to shareholders, warned of the danger of what he called 'toxic material'. And he has a point.

But derivatives can be looked at another way. What's interesting about markets that use derivatives is that their overall volatility goes down. Think about that early grain market. If derivative-using farmers are buying more in the spring (when the price was high) and less in the fall (when the price was low), the overall volatility in the price of grain should go down. The entire market should be smoothed.

It's for this reason that some suggest the use of credit derivatives is why long-term interest rates are historically low. Thousands of the world's banks, insurance companies, trusts and brokerages use credit derivatives to hedge their exposure to changes in interest rates by central banks. By studying the movement of those derivatives we have a new and transparent tool to assess what the market thinks Federal Reserve chairman Ben Bernanke will do at the next Fed meeting. Will he cut rates or raise them? When you consider that it wasn't long ago that the Federal Reserve simply raised or lowered rates without telling anyone, the idea of studying the price curves of interest rate derivatives to give a sense of what will transpire has brought down the overall risk of forecasting the future. And that has brought down long-term interest rates, which are really just gauges of how risky the future business environment looks (more risk, less transparency, the more people will charge to lend you money over the long-term).

In that sense derivatives are a genuine advance in financial forecasting. They've also improved life in general. How many people have benefited from our current low mortgage rates? Not only have derivatives provided a new transparency that allows everyone in the market to better negotiate the bumps and shocks of economic life, but the shocks that do emanate have less effect. We've reduced the possibility of financial shock and awe. That has to be, overall, a good thing.